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How Banks Create Money [ MS ] MS = Currency + DD of Public Banks [thru loans] C reate M ore DD.

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Presentation on theme: "How Banks Create Money [ MS ] MS = Currency + DD of Public Banks [thru loans] C reate M ore DD."— Presentation transcript:

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2 How Banks Create Money [ MS ] MS = Currency + DD of Public Banks [thru loans] C reate M ore DD

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4 FRACTIONAL RESERVE BANKING

5 RR Excess Reserves Total (Actual) Reserves PMC = M x ER, so 10 x.90 =$9 TMS = PMC[$9] + DD[$1] = $10 [ MS = Currency + DD of Public ] YOU deposit $1 with A 10% RR cents One Dollar One banks loan becomes another banks DD.

6 Excess Reserves Total(Actual) Reserves PMC = M x ER, so 10 x $1 = $10 TMS [$10] = PMC[$10] [ MS = Currency + DD of Public ] Your Bank Borrows $1 From The Fed [10% RR] RR One Dollar Bank Bank 0 One Dollar One Dollar Fed

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8 One year all u can eat hot wings at Hooters Dog that can YoYo MSCurrencyDD Public $1,000 DD [ MS = Currency + DD of Public ] MS MS grows by 10 multiple of $1, DD + PMC = TMS $ $90.00 $81.00 $72.90 $1, $9, $10, $1, $9, = $10, $ 9, PMC = ER[$900] x M[10] PMC = New Deposits [New Reserves]DD New Required ReservesRR=10% DD DD Created By New Loans [equal to new ER] Bank A B C D $ for a cat bodyguard Smoking cat

9 MS = Currency + DD of Public $1,000 DD [ MS = Currency + DD of Public ] MS MS grows by 5 multiple of $1, DD + PMC = TMS DD + PMC = TMS $ $ $ $ $1, $4, = $5, $4, PMC = ER[$800 x M[5] PMC = New Deposits [New Reserves] DD New Required ReservesRR=20% DD Created By New Loans [equal to new ER] Bank A B C D

10 MS = Currenc y+ DD of Public $1,000 DD [ MS = Currenc y+ DD of Public ] $1, DD + PMC = TMS DD + PMC = TMS $ $ $ $ $80.00 $1, $3, = $4, $ 3, PMC = ER[$750] x M[4] PMC = New Deposits [New Reserves] DD New Required ReservesRR=25% DD Created By New Loans [equal to new ER] Bank A B C D E MS grows by multiple of 4

11 Joe Biker 1. Joe Biker deposits $10, 000 in his bank. Suzie Rah Rah 2. Suzie Rah Rah borrows $8, 000 RR = 20% Suzie 3. Suzie pays $ 8, 000 for a used car. GoNow Auto deposits the $ in 2 nd Bank nd Bank lends Sports Shop $ 6, 400. $ 50, Eventually the MS will be $ 50, 000 Joe $ 10, 000 +$ 40, 000 =$ 50, 000 MS $ 10, 000 $ 8, 000 $ 18,000 MS $ 10, 000 $ 8, 000 $ 6, 400 $ 24, 400 MS = DD + Currency of the Public [A DD of $ 10, 000 will increase MS by another $ 40, 000 ($ 50, 000 MS ] RR=20% MS MS is $ 10, 000

12 NOTES: Banks create money by lending ER and destroy money by loan repayment. Purchasing bonds from the public also creates money.

13 MULTIPLE DEPOSIT EXPANSION PROCESS RR= 20% Bank Acquired reserves and deposits RequiredreservesExcessreserves Amount bank can lend - New money created ABCDEFGHIJKLMN Other banks $ $ $ $ $ PM C P M C in the banking system [ MxER] TMS = $ st 10 $ 357 ofthe$400

14 Maximum checkable- deposit expansion = ER x MMMMMMMM RR 1 = THE Money [Deposit] MULTIPLIER The M M is the reciprocal of the RR. MMMMMMMM Potential money Creation in the Banking System [PMC]

15 AP Econ [ MS = Currrency + DD of Public ] AP Econ [ MS = Currrency + DD of Public ] RR+ER=TR; TR-RR=ER; TR-ER=RR; M X ER =PMC ; PMC( Public )+DD=TMS; PMC(Fed)=TMS $40 million deposit DD 1. T he $40 million deposit of C urrency into DD would result in MS staying at ($8/$40/$160) million. [ MS composition changed from currency to DD ] $40 million deposit 2. The $40 million deposit of currency into ER checking accounts will create ER of ($20/$32/$40) million. Potential Money Creation 3. The Potential Money Creation of the banking system Potential TMS through loans is ($40/$160/$$200) mil. The Potential TMS DD [ all DD of the public] could be as much as ($40/$160/$200) mil. RR 4. The RR applies to checkable deposits at (banks/S&Ls/ credit unions/ all depository institutions). ER of $6,000 DD of $100, I f the D uck N ational Bank has ER of $6,000 & DD of $100,000 TRRR is 25% what is the size of the banks TR if the RR is 25%? ($25,000/$75,000/$31,000) [RR($____)+ER($___)+TR($____) Excess Reserves prior to new currency deposit ( DD ) = $0 Ben Bigbucks deposits in the banking system = $40 million Legal Reserve Requirement [RR] = 20% 25,000 6,000 31,000

16 [ MS = Currrency + DD of Public ] [ MS = Currrency + DD of Public ] deposits $1,000RR of 10%. 6. A stranger deposits $1,000 in a bank that has a RR of 10%. The maximum possible change in the dollar value of the local banks loans would PMCM X ERPotential TMS be $______. PMC[M X ER] in the banking system is $_____. Potential TMS could become as high as $_______. DD of $100,000RR is 10% 7. Suppose a commercial bank has DD of $100,000 and the RR is 10%. RR & ER are equalTR If the banks RR & ER are equal, then its TR are ($10,000/$20,000/$30,000). ER 8. Total Reserves (minus/plus) RR = ER. DD of $500,000RR is 10% 9. Suppose the Thunderduck Bank has DD of $500,000 & the RR is 10%. ER of $4,000TR If the institution has ER of $4,000 then its TR are ($46,000/$54,000/$4,000). ERare $4,000DD are $40,000RR is 10% 10. If ER in a bank are $4,000, DD are $40,000, & the RR is 10%, then TR TR are ($4,000/$8,000). main purpose of the RR 11. The main purpose of the RR is to (have funds for emergency withdrawals/ influence the lending ability of commercial banks). check for $1 12. If I write you a check for $1 & we both have our checking accts at the Poorman Bank, the banks balance sheet will ( increase/decrease/be unchanged). make loansrepaying bank 13. Banks (create/destroy) money when they make loans and repaying bank loans loans (create/destroy) money. bank loan is repaidMS 14. When a bank loan is repaid the MS is (increased/decreased). Fed Funds rate 15. The Fed Funds rate is a loan by one bank (to another bank/from the Fed). RR+ER=TR; TR-RR=ER; TR-ER=RR; M X ER =PMC ; PMC( Public )+DD=TMS; PMC(Fed)=TMS 9009,000 10,000

17 loans as cash 17. If borrowers take a portion of their loans as cash, the maximum amount by MS which the banking system increases the MS by lending will (increase/decrease). [ MS = Currrency + DD of Public ] [ MS = Currrency + DD of Public ] Leakages (limitations) of the Money Creating Process Leakages (limitations) of the Money Creating Process 1. Cash leakages [taking part of loan in cash] 1. Cash leakages [taking part of loan in cash] 2. ER (banks dont loan it or we dont borrow] 2. ER (banks dont loan it or we dont borrow] RR+ER=TR; TR-RR=ER; TR-ER=RR; M X ER =PMC ; PMC( Public )+DD=TMS; PMC(Fed)=TMS RR was lowered 16. If the RR was lowered [say, from 50% to 10%], the size of the monetary multiplier M M monetary multiplier [ M M] would (increase/decrease).

18 Money Supply = DD + Currency of the Public PMC PMCTMS ER Loans C rea. I n Potential $100[ 10 % RR] $100[ 10 % RR] [1 st Bank] [1 st Bank] System Total MS Banks / Public DD [$100] $90 $90 $900 $1,000 Fed / Public / B anks DD [$100] $90 $90 $900 $1,000 [* Fed buys bonds from public who put the money in their DD ] [* Fed buys bonds from public who put the money in their DD ] B anks / Fed Fed L oan [$ 100 ] $100 $100 $1,000 $1,000 [or sells bonds to Fed ] [or sells bonds to Fed ] PMC PMC TMS PMC PMC TMS ER Loans C rea. In Potential ER Loans C rea. In Potential $100 [ 20 % RR] [1 st Bank] [1 st Bank] System Total MS Banks / Public DD [$100] $80 $80 $400 $500 Fed / Public / B anks DD [$100] $80 $80 $400 $500 [* Fed buys bonds from public who put the money in their DD ] [* Fed buys bonds from public who put the money in their DD ] Banks / Fed Fed L oan [$100] $100 $100 $500 $500 [or sells bonds to Fed ] [or sells bonds to Fed ]

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20 [RR + ER = TR; TR - RR = ER; TR - ER = RR; MxER = PMC; PMC( Public )+1 st DD =TMS; PMC( Fed )=TMS] MS = Currency + DD of Public MS = Currency + DD of Public [Money borrowed from the Fed [or gained thru bond sales] is ER & can be loaned out] 9. RR is 25%; Econ Bank borrows $25,000 from the Fed ; its ER are increased by $______. P otential M oney C reation in the system is $_______. P otential TMS is $_______. 10. RR is 50 % ; a bank borrows $20,000 from the Fed ; this one banks ER are increased by $ _____. P otential M oney C reation in the system is $______. P otential TMS is $______ by $ _____. P otential M oney C reation in the system is $______. P otential TMS is $______ 11. RR is 20%; the Duck Bank sells $10 M of bonds to the Fed ; Duck Banks ER are increased by $___million. P MC in the system is $__________. TMS is $__________. increased by $___million. P MC in the system is $__________. TMS is $__________. 12. RR is 20%; Fed buys $50,000 of securities from Keynes Bank. Its ER are increased by $___________. Potential Money Creation in the banking system is increased by $___________. Potential Money Creation in the banking system is $______________. Potential TMS is $___________. $______________. Potential TMS is $___________ % RR; Fed buys $400 million of bonds from the Friar Bank. This one banks ER are increased by $_____million. banks ER are increased by $_____million. 14. RR is 50%; the Fed sells $200 million of bonds to a bank; its ER are (increased/decreased) by $_______. Potential Money Creation in the (increased/decreased) by $_______. Potential Money Creation in the banking system is (increased/decreased) by $________. banking system is (increased/decreased) by $________. 15. RR is 10%; a bank borrows $10 million from the Fed ; this one banks ER are increased by $_______ million. PMC in the banking system is ER are increased by $_______ million. PMC in the banking system is $_______million. Potential TMS is $_______million. $_______million. Potential TMS is $_______million. Banks and the Fed 25, , ,000 20,000 40,000 40, million 50, , , M 400 M

21 RR+ER = TR; TR-RR=ER; TR-ER=RR; M x ER = PMC; PMC( Public )+1 st DD = TMS; PMC( Fed ) = TMS Banks & Public (all DD of Public are subject to the RR; rest is ER & can be loaned out) 1. No ER & RR is 20%; DD of $10 M is made in the Thunder Bank. MS is $___million. ER increase by $___million. Potential Money Creation in the $___million. ER increase by $___million. Potential Money Creation in the banking system is $_____M. Potential TMS is $____million. banking system is $_____M. Potential TMS is $____million. 2. T here are no ER & RR is 25% & $16,000 is deposited in the Duck Bank. MS is $_______. This one bank can increase its loans by a maximum of $_______. This one bank can increase its loans by a maximum of $_______. Potential Money Creation in the banking system is $_______. $_______. Potential Money Creation in the banking system is $_______. Potential Total Money Supply could be $__________. Potential Total Money Supply could be $__________. 3. Econ Bank has ER of $5,000; DD are $100,000; RR is 25%. TR are $_______. 4. DD are $10,000; ER are $ 1,000; TR are $ 3,000; RR are _________. [TR-ER = RR]. 5. Nomics Bank has ER of $10,000; DD of $100,000; RR of 40%. TR are _________. With ER above, Potential Money Creation in the banking system is $__________. With ER above, Potential Money Creation in the banking system is $__________. 6. Friar Bank has DD of $100,000; RR is 20%; RR & ER are equal. TR are $________. 7. If ER in a bank are $10,000; DD are $200,000, & the RR are 10%. TR are $_______. 8. N o ER & RR is 25%. DD of $100,000 is made. MS is $_______. This single bank can increase its loans by $_______. PMC in the system is $________. TMS is $________. increase its loans by $_______. PMC in the system is $________. TMS is $________ ,000 12,000 48,000 64,000 30,000 $2,000 $50,000 25,000 40,000 30, ,000 75, , ,000 Banks and the Public Banks and the Public MS = currency + DD of Public

22 [RR + ER =T R; TR-RR = ER; TR - ER = RR; MxER = PMC; PMC( Public )+1 st DD = TMS; PMC( Fed ) = TMS] MS = Currency + DD of the Public MS = Currency + DD of the Public Fed Public DD [When Fed buys securities from Public, they will put the money in their DD ] Fed Public MS 16. RR is 50 %; Fed buys $10 M of bonds from the Public. MS is increased by _______. ER are increased by ____. PMC in the system is _______. P otential TMS is _______. Fed Public MS 17. RR is 25%; Fed buys $ 100 M of bonds from the Public. The MS is increased _______. ER are increased by ______. PMC in the system is _______. Potential TMS is ________. Fed PublicMS 18. RR is 50%; Fed sells $200 M of bonds to the Public. The MS is (incr/decr) by __________. ER are (incr/decr) by _________. PMC in the banking system is (increased/decreased) by _______. Potential TMS is (incr/decr) by __________. Fed Public MS 19. RR is 20%; Fed buys $5 million of securities from the Public. The MS is increased by _______. ER are increased by _______. Potential Money Creation in the banking system is _______. Potential TMS is _________. Fed Public MS 20. RR is 10%; Fed buys $50 million of bonds from the Public. The MS is increased by _______. ER are increased by _______. PMC in the banking system is __________. Potential Total Money Supply is __________. $10 M $5 M $10 M $20 M $ 100 M $75 M $300 M $400 M $200 M $100 M $200 M $400 M $5 M $4 M $20 M $25 M $50 M $45 M $450 M $500 M Fed and the Public Fed and the Public

23 All of t he $10,000 loan would be ER. Econ Bank could loan it all out so it could result in a PMC and TMS All of t he $10,000 loan would be ER. Econ Bank could loan it all out so it could result in a PMC and TMS of $50,000. [ M M of 10 x $10,000 = $50,000] RR is 20% $10, RR is 20% & Econ Bank borrows $10,000 from the Fed. The impact of this loan on the banks ER and then TMS are: MS = C urrency + DD of public [Remember again: MS = C urrency + DD of public ] (A) ER would increase by $10,000 & the maximum increase in TMS would be $50,000. (B) ER would increase by $8,000 & the maximum increase in TMS would be $50,000 (C) ER would increase by $8,000 & the maximum increase in MS would be $40,000 (D) ER would increase by $10,000 & the maximum increase in MS would be $40,000. (E) ER would increase by $40,000 & the maximum increase in MS would be $50,000. RR is 20% deposits $10, The RR is 20% & Joe Smith deposits $10,000 in the Econ Bank impact of this that he has been saving in a coffee can in a tree. The impact of this transaction on the ER potential increase in transaction on the ER of the Econ Bank & the potential increase in the money supply MS = C urrency + DD of public the money supply would be: [Remember: MS = C urrency + DD of public ] (A) ER would increase by $10,000 & the maximum increase in TMS would be $50,000. (B) ER would increase by $8,000 & the maximum increase in TMS would be $50,000 (C) ER would increase by $8,000 & the maximum increase in MS would be $40,000 (D) ER would increase by $10,000 & the maximum increase in MS would be $40,000. (E) ER would increase by $40,000 & the maximum increase in MS would be $50,000. T he MS [Cash or DD of the public] was $10,000 cash. When he deposited the $ 10,000, the Econ T he MS [Cash or DD of the public] was $10,000 cash. When he deposited the $ 10,000, the Econ Bank could loan out ER of $8,000. The $8,000 x M M of 5 became $40,000 for TMS of $50,000. Bank could loan out ER of $8,000. The $8,000 x M M of 5 became $40,000 for TMS of $50,000. So, $10,000 MS of cash increased MS by $40,000 to get the total money supply of $50,000. So, $10,000 MS of cash increased MS by $40,000 to get the total money supply of $50,000.

24 Money Creation Problems from the 2005 Macro MC Exam Money Creation Problems from the 2005 Macro MC Exam (87%) fractional reserve banking system (87%) 40. Under a fractional reserve banking system, banks are required to a. keep part of their demand deposits as reserves b. expand the money supply when requested by the central bank c. insure their deposits against losses and bank runs d. pay a fraction of their interest income in taxes e. charge the same interest rate on all their loans (72%) (72%) 41. If a commercial bank has no ER and the RR is 10%, what is the value of new loans this single bank can issue if a new customer deposits $10,000? a. $100,000 b. $90,333 c. $10,000 d. $9,000 e. $1,000 AssetsLiabilities Assets Liabilities Total Reserves: $15,000 DD: $100,000 Securities: $70,000 Loan: $15,000 (37%) RR is 12% (37%) 42. A commercial bank is facing the conditions given above. If the RR is 12% maximum amount of and the bank does not sell any of its securities, the maximum amount of additional lending additional lending this bank can undertake is a. $15,000 b. $12,000 c. $3,000 d. $1,800 e. 0 (53%)RR is 20%keep some excess reserves (53%) 43. Assume the RR is 20%, but banks voluntarily keep some excess reserves. $1 million increase in new reserves A $1 million increase in new reserves will result in a.an increase in the MS of $5 millionc. decrease in MS of $1 million b.an increase in the MS of less than $5 milliond. decrease in the MS of $5 million e. a decrease in the MS of more than $5 million The TR: $15,000, Securities: $70,000, and Loan: $15,000 total up to the $100,000 DD. Loan: $15,000 total up to the $100,000 DD. This bank would have to keep $12,000 of their $100,000 in RR. With TR of $15,000, they have $3,000 in ER to loan. They could increase MS by $5 M, but they are keeping some in ER, so MS will increase by less than $5 million.

25 Nominal Interest Rate Amount of money demanded (billions) DtDtDtDt % 8%6%4%2%0 Da [M2] – store of value money Money that we dont need for daily, weekly, or monthly transactions. We will invest more of it the higher the interest rate. We will hold less b ecause the opportunity cost increases. + = Transactions Demand, D t THE Total DEMAND FOR MONEY Rate of interest, i (percent) Amount of money demanded (billions) DaDaDaDa I nterest R ate O pportunity C ost Da [hold less] I nterest Rate O pportunity C ost Da [hold more] %5%5%5% M1M1M1M1 Da Da inversely Da varies inversely with the interest rate. Asset Demand, D a CDs or 1%1%1%1% Dt Independent of the interest rate Walking around money Total demand for money, D m

26 += Transactions Demand, D t Asset Demand, D a Total demand for money, D m Nominal Interest Rate Amount of money demanded [billions] DtDtDtDt Rate of interest, i (percent) Amount of money demanded [billions] DaDaDaDa Rate of interest, i (percent) Money market MS 1 E 5 1. At equilibrium 5% I.R., the amount of money demanded for transactions is (0/50/100) and the amount demanded as an asset is (0/50/100). 2. If the interest rate were 10%, the amount of money demanded for Dt would be (0/50/100) & the amount demanded as an asset would be (0/50/100). 3. Da slopes down because lower in. rates (incr/decr) the cost of holding money. DmDmDmDm MS MS 2

27 Nominal Interest Rate DmDm E MS [at E, money supplied ($200) = money demanded ($200)] recession Due to a recession, suppose the money supply increased is increased from $200 billion to $250 billion. Money Market The Dm curve represents the quantity of money people are willing to hold at various interest rates.

28 # of Bonds Nominal Interest Rate DmDm E MS 1 MS MS 2 [at E, money supplied ($200) = money demanded ($200)] surplus of A temporary surplus of $50 billion $50 billion beyond which the people wish to hold, buying They react by buying bondspushing bond bonds [pushing bond prices up prices up] to meet the desired level of liquidity. Money Market Price of Bonds P1P1 P2P2P2P2 S1S1 S2S2S2S2 E

29 1% GDP Nominal Interest Rate DmDmDmDm E MS 1 MS 2 Money Market PL SRAS AD Liquidity Trap stagnant economyinterest rates near or at zero Liquidity Trap – in a stagnant economy with interest rates near or at zero, an increase in MSrecession or depression gets worse increase in MS fails to stimulate AD, so recession or depression gets worse. people hoard their money. With low returns expected on financial investments, people hoard their money. Fiscal policy is needed here Banks are unwilling to lend in a slack economy. Fiscal policy is needed here. YDYDYDYD LRAS AD

30 Nominal Interest Rate DmDmDmDm E MS [at E, money supplied ($200) = money demanded ($200)] inflation $200 billion $150 billion Due to inflation, suppose the money supply is decreased from $200 billion to $150 billion. Money Market

31 Nominal Interest Rate DmDmDmDm E MS 1 MS 2 shortage of money A temporary shortage of money will require the sale of some bonds-which will make their price fall assets [bonds-which will make their price fall] to meet the money shortage need. Money Market S1S1S1S1 S2S2S2S2 Price of Bonds P1P1P1P1 P2P2P2P2 # of T-bills

32 graph of the money market (a) Draw a correctly labeled graph of the money market and show the impact of the financial investors actions on each of the following. (i) Demand for money (ii) Nominal interest rate 1. [3 pts] Assume that declining stock market prices in the U.S. cause many U.S. financial investors to sell their stocks and increase their money holdings. U.S. financial investors to sell their stocks and increase their money holdings. MS DM1DM1DM1DM1 Nominal Interest Rate r1r1r1r1 r2r2r2r2 Answers for 1. (a) (i) [2 points] 1.(a) (i) In an effort to preserve wealth, investors sell off stocks when market prices begin to decline. These new money holdings will increase the asset [speculative] demand for money. In the volatile market, investors will hold more money while determining hold more money while determining future needs. [2 pts: 1 pt for correct future needs. [2 pts: 1 pt for correct graph and 1 pt for Dm shifting right.] graph and 1 pt for Dm shifting right.] DM2DM2DM2DM2 Answers for 1. (a) (ii) [1 point for saying the interest rate increases] 1.(a) (ii) The nominal interest rate would increase because the demand for money increases as the D M curve shifts up, as shown above. for money increases as the D M curve shifts up, as shown above. M Quantity of Money Tutorial: These will shift the real Dm curve. 1. Changes in real aggregate spending, 2. Advances in banking technology. [ATMs available 24/7 decrease the need for cash (Dm)] 3. Change s in institutions [ability to get interest on checking accounts lead to an increase in Dm], 4. Riskiness of alternative stores of value [stocks]. Dm increases when stocks are not appealing.


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